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Natural monopoly

March 29th, 2003

My piece on oligopolies gave rise to a lively, and often vituperative, comments thread. As is usually the case, the substantive issues got lost in the name-calling (entertaining though the latter was at times). Attempting to extract some coherent issues from the thread, I focused on two:

  • whether some industries are naturally monopolistic and
  • what, if anything should be the role of competition policy (for historical reasons, this is called ‘antitrust’ in the US).

In this post, I’ll stick to natural monopoly. I think economists have tended to underplay the importance of natural monopoly, particularly in the period of microeconomic reform that began in the 1980s. There are three main factors leading to natural monopoly (or maybe, I like threeway classifications, and have organised a diverse set of factors into three classes).

First, physical economies of scale are important in a lot of different contexts. For a city the size of Brisbane (a million or so people), it makes sense to have just one airport, one major brewery, a handful of major hospitals and so on. For network distribution services (phones, electricity, water supply etc) the same point arises a bit differently. In physical terms, it’s optimal to have only a single distribution network in any given local area. This is pretty obvious, but there were a lot of silly claims in the 1990s based on the fact that since microcomputers had displaced mainframes, it was obvious that technology would in future be small-scale and inherently favorable to competition. The fact that the world’s microcomputer chips were made in a steadily shrinking number of plants costing a billion dollars apiece (and rising) escaped the attention of these gurus.

Second, the economic importance of information is increasing all the time and information is nonrival in consumption – giving information to me doesn’t make it any less available to you. So, the technically efficient procedure is for information to be produced once and shared freely. Again in the 1990s, the slogan ‘information wants to be free’ was repeated a lot. Unlike the idea that new technology is inherently small-scale, this slogan was at least half-right. Once information has been discovered it’s costly and wasteful to keep it secret or restrict its use. But the slogan is also half false. Discovering/producing information in the first place is costly and those who discover/produce it want to be paid in some way.

So far I’ve been talking about information of the “E=MC-squared” type, but another sort of information is equally important or more so in explaining the prevalence of natural monopoly. Human relationships, including long-term economic relationships depend on the beliefs, preferences and intentions of those involved, and these are hard to discover. I can discover my own intentions and beliefs by introspection and I can infer those of other people from observation and experience – the human capacity for self-deceptions means that the latter kind of information is sometimes more reliable than the former.

As a trivial example, when I write a column for the Financial Review, the opinion editor expects that I will check my facts before I submit the column – (I flagged my uncertainty about the authorship of the airlines cartoon I cited recently, but as it turned out I should have asked on my blog first). For some columnists and some papers, this isn’t a problem of course, but for papers that aspire to accuracy, it’s easier to rely on contributors who are known to be reliable than to take on new writers who may require more careful checking. This kind of problem arises in all kinds of employment and contractual relationships.

As Ronald Coase pointed out over 60 years ago, it is the transactions costs associated with this kind of information that explain why so much economic activity is arranged through firms and other organisations (governments, households, clubs, and now Internet-based virtual communities) rather than through markets. If it were not for transactions costs, even physical economies of scale would not produce monopoly, since the same asset could be shared by an arbitrarily large number of firms.

I’m going to leave the question of competition policy for another post, but I’ll observe that one factual implication of the arguments above is that competition policy makes a difference. If it were not for restrictions on mergers and for the tight regulation to which monopolies are often subject, a lot of industries that are currently oligopolies (dominated by a few firms) would be monopolies.

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